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The conventional wisdom about the bailouts of 2008 goes something like this. Federal regulators started off on the right foot by bailing out Bear Stearns and midwifing its sale to JPMorgan Chase. They were right to bail out AIG six months later, but botched the execution. And Lehman Brothers, the only exception to the bailout rule, showed once and for all that bankruptcy is not an adequate way to handle the collapse of a large financial institution.

But what if regulators hadn't bailed out Bear Stearns? If we conduct this simple thought experiment, it raises serious questions about both the conventional wisdom and the Obama administration's new proposals for regulating investment banks and bank and insurance holding companies. Bankruptcy starts to look much better, although it could use several market-correcting tweaks.

The Bear Stearns saga unfolded in March 2008. After the markets lost confidence in Bear and its $18 billion of cash reserves began to disappear, Bear Stearns chief executive Alan Schwartz called Tim Geithner, who was head of the New York Federal Reserve Bank. Geithner, then-Treasury Secretary Hank Paulson, and Ben Bernanke pushed Bear into the arms of JPMorgan, a much healthier bank. The deal was structured so that the creditors of Bear Stearns were fully protected, Bear's shareholders took a serious haircut, and the government kicked in a $29 billion guarantee of Bear's most dubious assets.

More by David Skeel

If regulators had decided not to bail Bear out, the short-term effects might have been jarring. Regulators were particularly worried about the extremely short-term loans--known as "repo" loans--that investment banks depend on for financing. A repo loan is structured as a sale of securities by the borrower to the lender, with a promise by the borrower to buy the securities back the next day. If there were a major default in this previously safe lending market, the market might have frozen up and major repo lenders who were not repaid might have been destabilized or even failed.

Some of these consequences might have ensued, but the risk of widespread ripple-effect collapses--also known as contagion effects or systemic risk--was almost certainly overstated. The creditors of Bear Stearns would have suffered losses, and the shareholders would have been wiped out. But this hard medicine would have sent a very clear message to the managers, creditors, and shareholders: Better watch what the company is doing, or you could get burned. In more technical terms, a Bear Stearns bankruptcy would have eliminated moral hazard--the tendency not to take precautions if you'll be spared the consequences of bad outcomes.

When Bear Stearns fell, Lehman Brothers was widely viewed as similarly vulnerable, since it too was highly leveraged and heavily exposed to subprime mortgages. Yet Richard Fuld, Lehman's chief executive, rejected a proposed investment by Warren Buffett and refused to seriously consider selling the company in the months after the Bear Stearns bailout. When Lehman filed for bankruptcy six months later, on September 15, 2008, no one even knew who Lehman owed money to and who the counterparties on its derivatives contracts were.

AIG was similar. The most impressive document produced by AIG on the eve of its collapse was a secret report designed to show federal regulators just how devastating a bankruptcy would be. As summarized in the New York Times, the report predicted that derivatives markets and the insurance industry could collapse if AIG defaulted. These responses made perfect sense if you assumed--as everyone did after the Bear Stearns bailout--that regulators would bail out any big, troubled financial institution. Not only was there no need to plan for bankruptcy, but the bailout strategy gave Lehman and AIG an incentive not to prepare for the worst. The more unprepared they were, the worse the bankruptcy option would look and the more likely a bailout would be forthcoming.

This, not the bankruptcy system, is why Lehman's collapse was so disastrous. Lehman, its suitor Barclays, and everyone else assumed the government was standing by with buckets of money. But regulators played bait and switch, deciding at the last minute not to provide bailout funds after all. Lehman's failure to prepare, and the way it was dumped into bankruptcy, were the problems. The bankruptcy itself has gone remarkably smoothly.

If Bear had been left to file for bankruptcy back in March, the managers and investors of Lehman and AIG surely would have acted differently in the weeks before their failures. The prospect of bankruptcy would have given them a very different perspective on the implications of their financial difficulties. At the least, they would have gotten their books in order and started looking for buyers for their businesses much earlier.